Flash Boys: A Wall Street Revolt

by Michael Lewis

  Leaving Chicago, the crews had raced across Indiana and Ohio. On a good day they were able to lay two to three miles of the line in the ground. When they arrived in western Pennsylvania they hit the rock and the pace slowed, sometimes to a few hundred feet a day. “They call it blue rock,” says Williams. “It’s hard limestone. And it’s a challenge to get through.” He found himself having the same conversation, over and over again, with Pennsylvania construction crews. “I’d explain to them that we need to go through some mountain, and one after another they would say, ‘That’s crazy.’ And I would say, ‘I know that’s crazy, but that’s how we’re doing it.’ And they would ask, ‘Why?’ And I’d say, ‘It’s more of a customized route to the owner’s wishes.’ ” To which they really didn’t have much to say except, “Oh.” His other problem was Spivey, who was all over him about the slightest detours. For instance, every so often the right-of-way crossed over from one side of the road to the other, and the line needed to cross the road within its boundaries. These constant road crossings irritated Spivey—Williams was making sharp right and left turns. “Steve, you’re costing me a hundred nanoseconds,” he’d say. (A nanosecond is one billionth of one second.) And: “Can you at least cross it diagonally?”

  Spivey was a worrier. He thought that when a person took risks, the thing that went wrong was usually a thing the person hadn’t thought about, and so he tried to think about the things he wouldn’t naturally think about. The Chicago Mercantile Exchange might close and move to New Jersey. The Calumet River might prove impassable. Some company with deep pockets—a big Wall Street bank, a telecom carrier—might discover what he was doing and do it themselves. That last fear—that someone else was already out there, digging his own straight tunnel—consumed him. Every construction person he talked to thought he was out of his mind, and yet he was sure the Alleghenies were crawling with people who shared his obsession. “When something becomes obvious to you,” he said, “you immediately think surely someone else is doing this.”

  What never crossed his mind was that, once his line was finished, Wall Street would not want to buy the line. Just the reverse: He assumed that the line would be the site of a gold rush. Maybe for that reason, he and his backers hadn’t thought much about how to sell the line until the time came to do it. It was complicated. What they were selling—speed—was only valuable to the extent that it was scarce. What they did not know was the degree of scarcity that would maximize the line’s market value. How much was it worth to a single player in the U.S. stock market to have an advantage in speed over everyone else? How much to twenty-five different players—to share the same advantage over the rest of the market? To answer these sorts of questions, it helps to know how much money traders can make purely from speed in the U.S. stock market, and how, exactly, they make it. “No one knew this market,” says Spivey. “It was opaque.”

  They considered holding a Dutch auction—that is, start at some high reserve price and lower it until the line was bought by a single Wall Street firm, which would then enjoy a monopoly. They weren’t confident that any one bank or hedge fund would fork over the many billions of dollars they assumed the monopoly was worth, and they didn’t like the sound of the inevitable headlines in the newspapers: Barksdale Makes Billions Selling Out Ordinary American Investor. They hired an industry consultant named Larry Tabb, who had caught Jim Barksdale’s attention with a paper he’d written called “The Value of a Millisecond.” One way to price access to the line, Tabb thought, was to figure out how much money might be made from it, from the so-called spread trade between New York and Chicago—the simple arbitrage between cash and futures. Tabb estimated that if a single Wall Street bank were to exploit the countless minuscule discrepancies in price between Thing A in Chicago and Thing A in New York, they’d make profits of $20 billion a year. He further estimated that there were as many as four hundred firms then vying to capture the $20 billion. All of them would need to be on the fastest line between the two cities—and there were only places for two hundred of them on the line.

  Both estimates happily coincided with Spivey’s sense of the market, and he took to saying, with obvious pleasure, “We have two hundred shovels for four hundred ditch diggers.” But what to charge for each shovel? “It was really a total wet finger in the air,” says Brennan Carley, who had worked closely with a lot of high-speed traders, and who had been hired by Spivey to sell his network to them. “All of us were just guessing.” The number they came up with was $300,000 a month, roughly ten times the price of the existing telecom lines. The first two hundred stock market players willing to pay in advance and sign a five-year lease would get a deal: $10.6 million for five years. The traders who leased Spread’s line would also need to buy and maintain their own signal amplifiers, housed in thirteen amp sites along Spread’s route. All-in, the up-front cost to each of the two hundred traders would come to about $14 million, or a grand total of $2.8 billion.

  By early 2010 Spread Networks still hadn’t informed a single prospective customer of their existence. A year after the workers had started digging, the line was, incredibly, still a secret. To maximize the line’s shock value and minimize the chance that someone else would seek to replicate what they had done, or even announce their intention to do so, they decided to wait until March 2010, three months before the line was due to be completed, before they tried to sell it. How to approach the rich and powerful men whose businesses they were about to disrupt? “The general modus operandi was to find someone at one of these firms one of us knew,” says Brennan Carley. “We’d say, ‘You know me. You know of Jim Barksdale. We have something we want to come over and talk to you about. We can’t tell you what it is until we get there. And, by the way, we want you to sign an NDA [non-disclosure agreement] before we come in.’ ”

  That’s how they went to Wall Street—in stealth. “There were CEOs at every meeting,” says Spivey. The men with whom they met were among the most highly paid people in the financial markets. The first reaction of most of them was total disbelief. “People told me later that they thought, Surely not, but let’s talk to him anyway,” says Spivey. Anticipating their skepticism, he carried with him a map, four feet by eight feet. He finger-walked them through his cross-country tunnel. Even then people still demanded proof. You couldn’t actually see a fiber-optic line buried three feet under the ground, but the amp sites were highly visible thousand-square-foot concrete bunkers. Light fades as it travels; the fainter it becomes, the less capable it is of transmitting data. The signals transmitted from Chicago to New Jersey needed to be amplified every fifty to seventy-five miles, and for the amplifiers that did the work, Spread had built these maximum-security bunkers along the route. “I know you guys are straight shooters,” one trader said to them. “But I never heard of you before. I want to see a picture of this place.” Every day for the next three months, Spivey emailed this man a photograph of the most recent amp site under construction to show him that it was actually being built.

  Once their disbelief faded, most of the Wall Street guys were just in awe. Of course they all still asked the usual questions. What do I get for my $14 million in assorted fees and expenses? (Two glass fibers, one for each direction.) What happens if the line’s cut by a backhoe? (We have people on the line who will have it up and running in eight hours.) Where is the backup if your line goes down? (Sorry, there isn’t one.) When can you supply us with the five years of audited financial statements that we require before we do business with any firm? (Um, in five years.) But even as they asked their questions and ticked their boxes, they failed to disguise their wonder. Spivey’s favorite meeting was with a trader who sat stone-faced listening to him for fifteen minutes on the other side of a long conference table, then leapt to his feet and shouted, “SHIT, THIS IS COOL!”

  In these meetings what didn’t get said was often as interesting as what did. The financial markets were changing in ways even professionals did not fully understand. Their new ability to move at compute
r, rather than human, speed had given rise to a new class of Wall Street traders, engaged in new kinds of trading. People and firms no one had ever heard of were getting very rich very quickly without having to explain who they were or how they were making their money: These people were Spread Networks’ target audience. Spivey actually didn’t care to pry into their warring trading strategies. “We never wanted to come across as if we knew how they were making money on this,” he said. He didn’t ask, they didn’t say. But the response of many of them suggested that their entire commercial existence depended on being faster than the rest of the stock market—and that whatever they were doing wasn’t as simple as the age-old cash to futures arbitrage. Some of them, as Brennan Carley put it, “would sell their grandmothers for a microsecond.” (A microsecond is one millionth of a second.) Exactly why speed was so important to them was not clear; what was clear was that they felt threatened by this faster new line. “Somebody would say, ‘Wait a second,’ ” recalls Carley. “ ‘If we want to continue with the strategies we are currently running, we have to be on this line. We have no choice but to pay whatever you’re asking. And you’re going to go from my office to talk to all of my competitors.’ ”

  “I’ll tell you my reaction to them,” says Darren Mulholland, a principal at a high-speed trading firm called Hudson River Trading. “It was, ‘Get out of my office.’ The thing I couldn’t believe was that when they came to my office they were going to go live in a month. And they didn’t even know who the clients were! They only discovered us from reading a letter we’d written to the SEC. . . .Who takes those kinds of business risks?”

  For $300,000 a month plus a few million more in up-front expenses, the people on Wall Street then making perhaps more money than people have ever made on Wall Street would enjoy the right to continue doing what they were already doing. “At that point they’d get kind of pissed off,” says Carley. After one sales meeting, David Barksdale turned to Spivey and said, Those people hate us. Oddly enough, Spivey loved these hostile encounters. “It was good to have twelve guys on the other side of the table, and they are all mad at you,” he said. “A dozen people told us only four guys would buy it, and they all bought it.” (Hudson River Trading bought the line.) Brennan Carley said, “We used to say, ‘We can’t take Dan to this meeting, because even if they have no choice, people do not want to do business with people they’re angry with.’ ”

  When the salesmen from Spread Networks moved from the smaller, lesser-known Wall Street firms to the big banks, the view inside the post-crisis financial world became even more intriguing. Citigroup, weirdly, insisted that Spread reroute the line from the building next to the Nasdaq in Carteret to their offices in lower Manhattan, the twists and turns of which added several milliseconds and defeated the line’s entire purpose. The other banks all grasped the point of the line but were given pause by the contract Spread required them to sign. This contract prohibited anyone who leased the line from allowing others to use it. Any big bank that leased a place on the line could use it for its own proprietary trading but was forbidden from sharing it with its brokerage customers. To Spread this seemed an obvious restriction: The line was more valuable the fewer people that had access to it. The whole point of the line was to create inside the public markets a private space, accessible only to those willing to pay the tens of millions of dollars in entry fees. “Credit Suisse was outraged,” says a Spread employee who negotiated with the big Wall Street banks. “They said, ‘You’re enabling people to screw their customers.’ ” The employee tried to argue that this was not true—that it was more complicated than that—but in the end Credit Suisse refused to sign the contract. Morgan Stanley, on the other hand, came back to Spread and said, We need you to change the language. “We say, ‘But you’re okay with the restrictions?’ And they say, ‘Absolutely, this is totally about optics.’ We had to wordsmith it so they had plausible deniability.” Morgan Stanley wanted to be able to trade for itself in a way it could not trade for its customers; it just didn’t want to seem as if it wanted to. Of all the big Wall Street banks, Goldman Sachs was the easiest to deal with. “Goldman had no problem signing it,” the Spread employee said.

  It was at just this moment—as the biggest Wall Street banks were leaping onto the line—that the line stopped in its tracks.

  There’d been challenges all along the route. After leaving Chicago they had tried and failed six times to tunnel 120 feet under the Calumet River. They were about to give up and find a slower way around when they stumbled upon a century-old tunnel that hadn’t been used in forty years. The first amp site after leaving Carteret was supposed to be near a mall in Alpha, New Jersey. The guy who owned the land said no. “He said he knew it was going to be some kind of terrorist target and he didn’t want it in the neighborhood,” said Spivey. “There’s always little gotchas out there that you have to be careful of.”

  Pennsylvania had proved even more difficult than Spivey had imagined. Coming from the east, the line ran to a small forest in Sunbury, just off the east bank of the Susquehanna River, where it stopped and waited for its western twin. The line coming from the west needed to cross the Susquehanna. That stretch of river was breathtakingly wide. There was one drill in the world—it would cost them $2 million to rent—capable of boring a tunnel under the river. In June 2010, the drill was in Brazil. “We need a drill that is in Brazil,” says Spivey. “That idea is quite alarming. Obviously someone is using the drill. When do we get to use it?” At the last minute they overcame some objections from Pennsylvania bridge authorities and were permitted to cross the river on the bridge—by boring holes through its concrete pylons and running the cable on the underside of the bridge.

  At which point the technical problems gave way to social problems. Leaving the bridge, the road split; one branch went north; the other, south. If you attempted to travel due east, you hit a dead end. The road just stopped, near a sign beside a levee that said, Welcome to Sunbury. Blocking the line’s path were two big parking lots. One belonged to a company that manufactured wire rope, the cable used on ski lifts; the other was owned by a century-old grocery store named Weis Markets. To reach its twin in the Sunbury forest, the line needed to pass through one of these parking lots or travel around the entire city. The owners of both Weis Markets and the Wirerope Works were hostile or suspicious, or both; they weren’t returning calls. “The whole state has been abused by coal companies,” Steve Williams explained. “When you say you want to dig, everyone gets suspicious.”

  Going around rather than through the town, Spivey calculated, would cost several months and a lot of money and would add four microseconds to his route. It would also prevent Spread Networks from delivering the cable on time to the Wall Street banks and traders ready to write checks for $10.6 million for it. But the guy who ran the wire rope factory was for some reason so angry with Spread’s local contractor that he wouldn’t speak to them. The guy who ran the Weis Markets was even harder to reach. His secretary told Spread that he was at a golf tournament, and unavailable. He’d already decided—without informing Spread Networks—to reject the somewhat strange offer of low six figures plus free high-speed Internet access they had offered him in exchange for a ten-foot easement under his parking lot. The line passed too close to his ice cream–making plant. The chairman had no interest in signing over a permanent easement that would make it difficult to expand the ice cream plant.

  In July 2010 the line dropped back underground beneath the bridge in Sunbury and just stopped. “We had all this fiber out there and we needed it to talk to each other and it couldn’t,” said Spivey. Then, for some reason he never fully understood, the wire rope people softened. They sold him the easement he needed. The day after Spread Networks acquired lifetime rights to a ten-foot-wide path under the wire rope factory’s parking lot, it sent out its first press release: “Round-trip travel time from Chicago to New Jersey has been cut to 13 milliseconds.” They’d set a goal of coming in at under 840 miles and beaten i
t; the line was 827 miles long. “It was the biggest what-the-fuck moment the industry had had in some time,” said Spivey.

  Even then, none of the line’s creators knew for sure how the line would be used. The biggest question about the line—Why?—remained imperfectly explored. All its creators knew was that the Wall Street people who wanted it wanted it very badly—and also wanted to find ways for others not to have it. In one of his first meetings with a big Wall Street firm, Spivey had told the firm’s boss the price of his line: $10.6 million plus costs if he paid up front, $20 million or so if he paid in installments. The boss said he’d like to go away and think about it. He returned with a single question: “Can you double the price?”

  _____________

  * The principal data center was later moved to Aurora, Illinois, outside Chicago.

  CHAPTER TWO

  BRAD’S PROBLEM

  Up till the moment of the collapse of the U.S. financial system, Brad Katsuyama could tell himself that he bore no responsibility for that system. He worked for the Royal Bank of Canada, for a start. RBC might be the ninth biggest bank in the world, but it was on no one’s mental map of Wall Street. It was stable and relatively virtuous, and soon to be known for having resisted the temptation to make bad subprime loans to Americans or peddle them to ignorant investors. But its management didn’t understand just what an afterthought their bank was—on the rare occasions American financiers thought about them at all. Brad’s bosses had sent him from Toronto to New York back in 2002, when he was twenty-four years old, as part of a “big push” to become a player on Wall Street. The sad truth about the big push was that hardly anyone noticed it. As a trader who moved to RBC from Morgan Stanley put it, “When I got there, it was like, ‘Holy shit, welcome to the small time!’ ” Brad himself said, “The people in Canada are always saying, ‘We’re paying too much for people in the United States.’ What they don’t realize is that the reason you have to pay them too much is that no one wants to work for RBC. RBC is a nobody.” It was as if the Canadians had summoned the nerve to audition for a role in the school play, then turned up for it wearing a carrot costume.